Q&A: What is a Keynesian stimulus and will it work?

A Keynesian–style stimulus happens when policy-makers deliberately seek to stimulate one or more of the components of aggregate demand to boost output, jobs and incomes during an economic recession.

Keynesians tend to believe that an economy can get stuck at high levels of unemployment with national output persistently below its potential (i.e. operating with a negative output gap). When business and consumer confidence is low (animal spirits have worsened) there is a danger that high rates of saving can make a recession worse. This is known as the paradox of thrift. In this situation weaker demand for goods and services causes further job losses and can cause negative multiplier and accelerator effects particularly in industries that supply components and raw materials to manufacturers and service businesses.

So a Keynesian stimulus is designed to actively manage the level of and rate of growth of aggregate demand.

An example would be to inject extra government investment into infrastructure projects and finance this through a higher level of government borrowing. Keynesian believe that the positive effect on national income and jobs would help to reduce the risk of a higher budget deficit ‘crowding out’ activity in the private sector. Economist David Blanchflower has been lobbying for a huge public sector investment programme as a way of combating what he fears will be a return to mass unemployment with well in excess of three million people out of work.

Another example would be tax cuts targeted at lower-income consumers, targeted at this group because they tend to have a higher marginal propensity to spend any gains in income.

Some fiscal stimulus to demand is inevitable in a recession – this is due to the workings of the automatic stabilisers - the in-built social welfare net which increases government debt during recessions. When unemployment is rising, the government automatically provides more in welfare assistance. And in a recession the revenue from taxation also diminishes.

Some evaluation points

1. Fiscal policy may be more effective than monetary policy during a credit crunch because in today’s special circumstances, low interest rates have little impact if credit is not easily available. In the past monetary policy has been the dominant tool of short-term demand management but if zero interest rates seem to have little impact, the attention tends to switch to fiscal policy instead.

2. Are tax cuts to be preferred to extra government spending?

3. What are some of the potential effects of a huge government borrowing spree for the distribution of income and wealth?

4. No one knows for sure just how large are the fiscal multipliers from extra government spending or a tax cut – if they are large then a modest fiscal stimulus can have a significant effect on demand. But the likely depth of the recession means that a Keynesian stimulus package will have to be very large indeed.

5. The likely scale of government borrowing is enormous and there are real fears about what this will mean in the medium term for the costs of servicing government debt and the likely tax increases in years to come. Average inflation and interest rates are likely to be higher because of the increase in government borrowing and the supply of money – this will constrain a future recovery period. But it may stave off the damaging consequences of deflation in the near term. The employers’ organisation the CBI is warning about the dangers of a further rise in state spending and borrowing – “a further significant fiscal stimulus is unaffordable and would lead to businesses and households retrenching in fear of higher tax bills.”

6. What might happen to the UK economy when a Keynesian style fiscal stimulus is ended? Will there be sufficient confidence and momentum in the economy to keep a recovery going?

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QA_Keynesian_Stimulus.doc